By Ankit Mital
The Gold Standard Act 1925, introduced on April 28th 1924 in the House of Commons by the then chancellor of the exchequer Sir Winston Churchill, was an infamous event in the world’s monetary history. Despite having never showed the slightest interest in economics, Sir Winston was nevertheless put up at No. 11 (official residence of the chancellor) by the then Prime Minister Stanley Baldwin who believed in keeping his friends close and enemies closer.
The leading bankers and economists of the era (with the notable exception of John Maynard Keynes) held an almost dogmatic belief in virtues of pegging the currency to the shiny metal*. Though in order to finance the deficit during the war, the European currencies had temporarily abandoned the Gold Standard since the global gold supply simply couldn’t keep up with the government’s demand for Money. The British economy and indeed that of most of Europe hadn’t still emerged from the ravages of the First World War. But with the war now half a decade behind, that very clique of bankers, led by Montagu Norman, the then Governor of the Bank of England, pressed on the government to return to the gold standard. They saw it “as a moral commitment on part of the British nation to those… who had placed their assets, their confidence and their trust in Britain and its currency”(Liaquat Ahmed, Lords of Finance). In some way they were correct. As today we naturally assume dollar to be a safe haven, rewind a little less than a century, that crown was held firmly by the pound. By the virtue of having an extremely stable currency Britain was effortlessly able to attract capital at a minimal cost from all over the world. Thus to claim London’s ‘rightful place as the epicenter of global finance’, it was necessary to restore the ‘confidence’ in the pound. With this belief, the Bank of England along with Senior Treasury officials put all their might behind the campaign to persuade Sir Winston to return the pound to the gold standard. But with Britain experiencing the highest unemployment rate in all of Europe and a sluggish economy, the idea of raising the value of the pound and tying it up with gold was not the most appetizing one to say the least. The great man though initially awfully reluctant to the idea, he eventually abandoned his famous intuitions and thus gave in, trusting the judgment of those who were ‘experts’ in the field. Britain returned to the Gold Standard at the prewar exchange rate, with scant regard for the domestic price of goods which were ten percent too high for that rate of exchange.
This proved to be a fatal error for the British economy, and in fact for that of the whole world. It first strangled the British economy by making credit expensive via high interest rates and its exports uncompetitive via an artificially overvalued currency. The high interest rates were necessary to attract gold deposits. At that moment however most of the world’s reserves were in the vaults of the U.S. Fed. Owing to their special personal relationship, the Governor of bank of England was able to persuade the chief of New York Fed, Benjamin Strong to lower the lending rates in the U.S. to assist the transfer of gold to Britain. This decision to lower U.S. lending rates further inflated the already huge bubble in the U.S. stock markets, which culminated in the Great Wall Street Crash of 1929 and the Great Depression. It was as one can see fundamentally the combination of artificial exchange rate and interest rate levels, in disharmony with the domestic economic factors, current account balance, prices, inflation, government deficits, unemployment which led to the period of economic hopelessness which we today call the Great Depression. Unfortunately it seems the lessons from that period have not been learnt.
The Treaty of Maastricht of 1992, the foundation of the common European currency was a result of this ignorance of both economic history and rational. The euro has in the past year been vacillating from one crisis to the other. With it still reverberating from the Greek and Irish crises and the Portuguese, Spanish and maybe even an Italian solvency crisis looming large, the euro faces an existential threat.
The Exchange Rate Mechanism (ERM) established in 1979, with aim of keeping mutual European exchange rates within a narrow band was the stepping stone for the common currency. The benefits of stable exchange rates were quiet apparent. The next logical step after the ERM was the adoption of the Euro. It promised benefits of elimination of exchange rate risks from continental trade and investments, elimination of transaction costs and hence more competitive production costs and higher continental trade. However the aims were not entirely economic in nature. The adoption of the Euro had been put as a precondition by the French to the Germans to allow its reunification. The French wanted to commit a newly united and hence ever more powerful Germany to the European project via monetary union. Being anchored to the Deutsche mark, the other continental nations wanted to benefit from its stability and strength.
The adoption of euro warranted that states achieve five convergence criteria, so that the currency would reflect the common economic realities of all the economies. They pertained to Inflation (not more than 1.5% more than the three best performers), Fiscal Deficit (not more than 3% of GDP), Government Debt (not more than 60% of GDP), Exchange Rate (joined the ERM and hadn’t undertaken devaluation) and long-term Interest rates (not more than 2% higher than that of three lowest inflation states). The idea behind all these criterions was pretty obvious. Since all these factors have a bearing on the exchange rate the adoption of a common currency required the states to be performing in the same vein. So far so good. But framer forgot a small little thing. The states were required to adhere to these criterions only until the euro was adopted. After that although there existed the Stability and Growth Pact (SGP) 1997 to monitor member economies, there was no constitutional obligation on part of the member nations to follow these sound macroeconomic principals. But what did this pact commit? That members must follow exactly the same fiscal policies irrespective of individual economic realities. The alternative would have been to allow members to follow divergent economic policies. However, this would have brought down the whole edifice on which the common currency was built. This choice between a rock and a hard place was extremely eloquently articulated by the former Italian Prime Minister and then President of the European Commission as “the stability pact is stupid, ...(and) divergent economic policies are crazy.”
The weakness of the pact was exposed by its very authors, the Germans and the French, who watered it down in 2005 to accommodate the deficits they had built up in the preceding years. Now to assume that all the member nations would scrupulously follow these rules was asking for too much. It would have required yogic discipline on part of the managers of national economic policies and utter disregard for economic cycles for all member states to follow similar economic policies all the time.
As the Greek and the Irish crisis unraveled, these very problems came to the fore. PIGS (Portugal, Ireland, Italy, Greece and Spain, maybe the pun is intended), as the problem kids of the eurozone are collectively known, have been running huge fiscal deficits either due to irresponsible fiscal policies or in wake of the recession. Now they are seeking to freeride on the back of the solid German and the French public finances in the form of bailouts and cheaper than otherwise credit. The newly floated proposal for Eurobonds (issued by the European Central Bank) is another such attempt where the funds borrowed by irresponsible governments will be guaranteed de jure by the whole of Eurozone but de facto by the German and French taxpayers. It would not only lower the ratings of individual sovereign debt, making the raising of debt costlier for responsible economies, it would put the burden of any future sovereign default in the Eurozone on the stronger economies.
The Irish who, until recently committing to raise them, have a corporate tax rate of 12.5% as compared say, 33.33% in France. The Greeks have a debt to GDP ratio of 120%. Now their bankrupt governments are asking the responsible citizens of France and Germany to bail them out with their savings. Ofcourse, the Greeks and the Irish are now being asked to make deep cuts to close up the structural fiscal deficits. The pace of these cuts is alarming though. However one can’t blame the Germans and the French for forcing the issue since they are footing up the bill to clear up the mess and the closing of deficits is essential to ensure repayment of debt and maintenance of the confidence in euro. In normal times, these states would have resorted to inflationary policies to wipe out their debts. However, this is not an option in a monetary union. Thus in order to keep the euro alive, the weaker European economies shall be condemned to falling standard of living and sluggish growth.
So for countries like Greece, whose growth is now stifled by euro, is exiting the monetary union an option? It would mean financial mayhem, redenomination of contracts and financial obligations, debt restructuring, run on banks with people pulling out deposits from banks and ultimately the decimation of the Greek economy and financial system.
As a solution to the current crisis, the European Commission has put forward more stringent proposals for stronger economic governance within the Eurozone, involving punitive measures to enforce budgetary discipline. It would simply imply national democratically elected governments eschewing their ability to spend and tax as per their mandate. This means the undermining the sovereignty of member states, surrendering national democracy to the bureaucrats of Brussels. There is no dearth of those Europhile federalists who see the next logical conclusion to the European Union as a sort of United States of Europe. In fact if the proposals currently mulled over are put into practice and there is high probability that they may be, one might see a European treasury replacing national ones. Would such an institution be impervious to social discontent and upheaval or even a revolution from either the left (irked by conservative fiscal and monetary policies) or the right (determined to protect national identity, political and fiscal independence)? The protests one is witnessing on the streets of Athens and Dublin today may just be sideshow in comparison to what future might hold for a Federal Europe. The Baltic States who joined the Euro bandwagon just recently and the east European aspirants readying themselves to jump on it are particularly vulnerable to such upheavals and may permanently threaten the stability of such an institution. But as we have seen, in the absence of a Federal Europe or a European treasury, the euro is bound to fail, condemning the Eurozone to instability and recurring sovereign crises and bailouts.
Edmund Conway, the former Economics Editor of The Telegraph recently (December 14th, 2010) wrote a premature but possibly inevitable obituary of the euro - “The euro was doomed from its very beginnings. Its progenitors failed to realise that it is impossible to have full monetary union and a completely free market without instituting some kind of centralised treasury. It was this, in the end, that contributed to the fatal imbalances that eventually destroyed the euro: one half of euroland (Germany) was allowed to live frugally; the other recklessly (Portugal, Greece, Ireland, Italy, Spain). Such imbalances are fine in a loosely-connected group of countries, but not when you are yoked to a single currency and interest rate. Sad as the euro’s collapse was, it was inevitable from the start.”
*Gold Standard – Under the system of gold standard, each unit of currency is supposed to be backed by a predetermined unit of gold. So when a country wishes to increase its money supply, the central bank prints new money and uses it to buy gold. This brings new money in circulation which is backed by gold. Why gold you would ask? The decline of barter economy saw the rise of gold as a unit of exchange. By the virtue of being durable, scarce (in fact in all of human history the total amount of gold mined in volume is astonishingly just 8489 cubic meters) and precious, gold bullion was ideal as a unit to back currency. The belief behind backing the currency by gold was that it made the “promise to pay the bearer of this note…” a credible one, since an individual could actually go to the central bank and demand something tangible, that is gold in exchange for paper money.
